And how you warned him not to do anything stupid?

How’d that turn out?

The next day, we’re all sober

Maybe it went something like this:

The next morning, light creeped into the room and revealed what your friend had done.

Drunk in denial

What happened when you told your friend he was drunk and that he should just go home and sleep it off?  The same thing that happens when you tell someone they are in investing in a bubble:

Denial.

Looking back, everyone can admit they got drunk.  But when the beer is flowing or your investment returns are growing, it’s another story.

Instead of waiting for the inevitable hangover, why not put down the glass?

How to get sober

When you’re really drunk, it’s hard to tell which way is up and which is down.  The same is true for investors caught up in a bubble.

Listening to people with opposing opinions to you, people who believe there is a bubble being blown, is the only way you might sober up.  Next time someone warns you about a bubble, listen carefully.  Always question what is accepted as ‘common sense’ or what feels right to you.

Otherwise, you might not like what you wake up to the morning after.

Related posts:

1. What Cinderella Can Teach You About Story Stocks With Happy Endings
2. Are Your Emotions Keeping You From Beating The Market?
3. The Hamster’s Guide to Investing

Michael Oher is no ordinary man, and the position he plays is no ordinary position.  As Lewis shows his readers, the salary for left tackles now clocks in as the second highest paid position in the NFL, right behind quarterbacks.  The reason why forms the backdrop to Lewis’s story:

The left tackle protects the quarterbacks blindside.

Evolution of the blind side

Before the 80s, that wasn’t such a big deal.  But then speedy giants like Lawrence Taylor exploded onto the professional football scene to deliver blow after pounding blow to unsuspecting quarterbacks

They came through the blind side.

Before Lawrence Taylor, sacks weren’t even kept track of.  After Lawrence Taylor, football managers realized something had to be done to protect their most valued asset.

That something was to find opposing giants of men who had the reflexes of a lightweight boxer and the protective instincts of a mother.  Gentle giants like Michael Oher.

Without a guy like Oher, a powerful linebacker can rush through the line and smash a quarterback into the ground, sometimes with disastrous consequences.   In a 1985 game between the Redskins and the Giants, Lawrence Taylor delivered a career ending injury to Joe Theismann by snapping his leg in half.  Lewis paints the opening of the scene vividly in his book:

Four Mississippi: Taylor is coming.  From the snap of the ball Theismann has lost sight of him.  He doesn’t see Taylor carving a wide circle behind his back; he doesn’t see Taylor outrun his blocker upfield and then turn back down; and he doesn’t see the blocker diving, frantically, at Taylor’s ankles.  He doesn’t see Taylor leap, both arms over his head, and fill the sky behind him.  Theismann prides himself on his ability to stand in the pocket and disregard his fear.  He thinks this quality is a prerequisite in a successful NFL quarterback.  “When a quarterback looks at the rush,” he says, “his career is over.”  Theismann has played in 163 straight games, a record for the Washington Redskins.  He’s led his team to two Super Bowls, and won one.  He’s thirty-six years old.  He’s certain he still has a few good years left in him.  He’s wrong.  He has less than half a second.

- From The Blind Side by Michael Lewis, page 19, 2006, W.W. Norton & Company, Inc.

To beat the market, you’ve got to know where the blind side is.

If you don’t, you won’t see something big and nasty rushing right through it at just the wrong time.  And since in the stock market you can’t hire a guy like Michael Oher to protect your back, you’d better get as far away from the blind side as possible.

Otherwise, instead of a broken leg, you might be left with broken dreams.

The blind side for most investors

Where is the real blind side of most investors?

Financial bubbles.

Most investors fall into one of two camps:

1. They deny obvious bubbles (this is where most people fall) before they pop
2. They acknowledge that there is a bubble, but think they can play it just right and get out with big gains

The first camp of investors gets crushed by the market.  And the second, despite knowing about the bubble, rarely get out in time.  Investing in asset bubbles is always a tremendous risk, and leaves investors exposed with no gentle giant to protect them.

Instead of standing with your back to the blind side, not knowing whether you’ll be able to dodge the impact of a bursting bubble, why not get as far away from it as possible?

The age of bubbles, and the biggest blind side of them all

This is the age of bubbles.  In the late 90s, we had the Nasdaq bubble.  From the turn of the millennium on, it was the housing bubble.  And just a little over a year ago the emerging markets bubble burst.

All of these bubbles blind-sided scores of investors.  And now another bubble threatens much of America.

It’s one being blown by enormous spending increases in Washington, incredibly fast monetization of debt (read: printing money), and bailouts and now nationalizations taking place.

Plus, there is a clear pin that will one day pop the bubble: The massive accumulation of dollar reserves abroad that one day will come back home.

Today there are many places to invest your money that shout ‘value’.   But there is also another bubble waiting to burst.

So it might be time to get as far away as possible from the blind side.

To learn more finding real values in today’s crazy markets and avoiding punishing blows, subscribe to Happily Ever After Investing.

Related posts:

1. Is Drinking Drowning Your Investing Dreams?
2. Are Your Emotions Keeping You From Beating The Market?
3. What Cinderella Can Teach You About Story Stocks With Happy Endings

And the ones that beat the odds?  Many of them only win because of luck.

Luck that runs out at just the wrong time.

There are many reasons why, and the the truth is this:  If you can’t overcome most of them,  you won’t stand a chance of beating the stock market over the long run.

Reason #1: You’re in a losing game

Simple logic makes it immediately clear why the majority of people can’t beat the stock market, with or without luck.

The average return of all investors is equal to the stock market’s return minus taxe, trading costs, and management fees. 

To beat the market, you’ve got to overcome all three.

Reason #2:  You ride the roller coaster ride from hell, then jump off

To have any decent chance of beating the market, you’ve got to be willing to buy when there is blood running down the streets, trickling into the gutters.  That’s not the easiest thing to do after you’ve seen your life savings cut in half, or are afraid for your job.  And if you already lost your job?

Fuggedaboutit.

When things look bleak, it seems smart to sell and hold onto whatever you have left.  And so people sell at just the worst time, when they should be buying even more, or shifting from what they’ve got into even better values unearthed by the shaking out of the market.

It’s like you were stuck on an out of control roller coaster, and had no idea when or where it would stop.  Instead of waiting for it to plunge into the ground, you’ll probably jump out near the bottom.  Sometimes right before it rockets right back up.

If you can’t control your emotions while investing, you won’t wait or strap yourself in to the best bargain rides out there – you’ll jump, and most likely at the wrong time.

Reason #3:  You believe in methods that don’t work

There are scores of systems and methods that supposedly beat the market.  Many of them are based on technical analysis or tips on story stocks that are supposedly about to rocket off into space.

Studies clearly show technical analysis doesn’t work, at least for most people.  And the odds are sometimes better for Lucky at the horsetrack than from any given stock tip.

Instead of trying to win a losing game, why not search out those areas in the markets where the odds are stacked in your favor? 

Value investing has worked for everyone who adhere to its methods over the long run.  It’s worked for generations, and thanks to human-kind’s tendency to do stupid things based on their emotions, will likely continue to work for generations more (or at least until supercomputers rule the world).

Reason #4: You trust sharks with your money

Many people still place tremendous faith in mutual fund managers, investment advisors, and stock analysts. 

But most of them can’t help you beat the market.

As the chairman of the Vanguard group, John , Bogle, puts it, over every 10 year period since the sixties, 90% of mutual fund managers have underperformed the market averages.

Investment advisors & brokers aren’t much better – many times they are looking out for #1, pushing you into inappropriate funds or stocks just to get their own cut.

And stock analysts?  Well, most of them rate stocks highly when they’re expensive and lowly when they’re cheap. 

No matter what, don’t give sharks your money – you might lose an arm and a leg trying to get all of it back.

Over to you

What do you think are some other reasons investors lose to the markets?  Please share your thoughts below.

And don’t forget to  subscribe to Happily Ever After Investing  for more tips to help you beat the market safely.

Related posts:

1. Why Some People Almost Always Make Money in the Stock Market
2. Are Your Emotions Keeping You From Beating The Market?
3. How To Run Against The Wind For Good Stock Market Results

Or driving you crazy?

It’s a pretty safe bet that emotions are the #1 reason why most investors underperform the stock market.  Either we get greedy and buy a company for too much, or we get scared and sell for too little.

If you do the opposite, it’s probably enough to beat the market over the long run.

What’s ironic is that if everyone controlled their emotions, on average everyone would lose to the market.  The only winners would be those balanced precariously on Lady Luck’s shoulders.

Thankfully for you and me, that just isn’t the case.

Two centuries later, people are still crazy

Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. To trace the history of the most prominent of these delusions is the object of the present pages. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

(Preface, Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, 1841)

Almost two centuries later, these words still ring true.

If you can stay sane while the world is going crazy,you can do better than the market.  All you have to do is refuse to buy businesses floating high on a bubble, sticking with businesses that are selling at a discount, and then be willing to scoop in and pick up the best values once the bubble has burst.

Don’t catch the fever, and you can turn your emotions upside down and profit while everyone else is running off a cliff.

But there are other ways emotions can make you do silly things you will regret in the market.

Breaking up is hard to do

Once you buy a stock, you become attached to it.

Even exceptionally talented investors can have a hard time looking at a stock they own with different eyes than at the rest of the stock market.

When it goes up, you pat yourself on the back and tell yourself good job.  When it goes down, you might ignore the loss and hope the stock returns to the level you bought in at.

I know, I’ve done both.  We all have.

But it’s stupid.

You shouldn’t get attached to a stock just because it’s your stock.

If you would buy an identical company today (completely ignoring its past price history), you should hold onto the stock or add to it.  If not, seriously consider selling.

Don’t let your attachment to a stock keep you stuck in a relationship you’ll regret.

Over to you

Have any good stories on how emotions have gotten you to do something stupid?  If you want, you can share below.

And if you want someone to hold you back from running off that cliff, subscribe to Happily Ever After Investing today.

Related posts:

1. How To Run Against The Wind For Good Stock Market Results
2. 4 Reasons Why Most People Can’t Beat The Stock Market
3. The Hamster’s Guide to Investing

Against the Wind is an emotional song and tells a story that’s easy to identify with.

And the stock market is an emotional place.  Years worth of work, stored up in your savings, can up and vanish in the wind in a heartbeat’s time.

If you do the wrong thing when the wind comes, those savings can permanently disappear.

So you better be ready.

In the market you either run into the wind (contrarian / value investing), strap on a hang glider to float with it (index fund investing), or try to outrun it and inevitably get blown over.

If you want to do better than the stock market, you’ve got to run against the wind.

How to run against the wind

The key to running against the wind is simple:  You’ve got to feel differently than everyone else, and do what everyone else won’t.

While everybody is scared and running away from the wind, you’ve got to be brave, excited even, and run straight into it.

Search for the bargains that bad times inevitably bring.  Learn the lessons of value investing well.  Find out where the true values lie and avoid falling into value traps.

Don’t be afraid to sell stocks that have losses when you can change them for ones that are a much better value.

Then, when the storm has passed, you’ll be sitting pretty.

But never stop running against the wind.  I know I won’t.  And I hope you come along on that journey, too.

Related posts:

1. 4 Reasons Why Most People Can’t Beat The Stock Market
2. Are Your Emotions Keeping You From Beating The Market?
3. Why Some People Almost Always Make Money in the Stock Market

Let’s start with what we know:  The only statistically proven method of beating the market is to buy things for less than they’re worth.

This is the essence of value investing, which is just as much about buying great companies for good prices as it is about buying mediocre companies for bargain basement prices.

If you’re an investor and you haven’t been hiding under a rock over the last several decades, you should know that all of the research proves that value investing works.  There are reams of studies that prove that buying companies with low price to earnings, book value, or free cash flow ratios beats the market.

Even apostles for the efficient market theory have to quietly admit the worth of value investing toward the end of their books, books that seek to prove that you can’t beat the market.

Except you can, if you follow what value investing teaches.

But maybe you can’t beat the stock market, even though you know much of what there is to know about value investing.  If so, why?  What is holding so many people back from not merely acknowledging that value investing works, but grabbing hold of that knowledge and using it to beat the bejesus out of the market?

And why do some people almost always make money in the stock market?

Maybe a joke will clear things up:

The value investor and the efficient marketer

A value investor, let’s call him Warren, and an efficient market theorist, let’s call him John, are walking down a side alley when something catches Warren’s eye.

“Hey John, is that a $100 bill lying in the middle of the street?  We should grab it before someone else does!” Warren asks.

“No, can’t be,” John replies, “someone would have grabbed it by now.  Even if there is a bill there, it’s gotta be fake.”

Warren, ignoring John’s advice, snatches the $100, happy with his find.  John is happy with his wisdom, because Warren must be a fool to think there are real $100 bills just laying around waiting for the taking.

Real life or stupid joke?

You may think that this is just a stupid joke, but it is the same point that Warren Buffett makes about people when they are first exposed to the idea of value investing – they either get it, or they don’t get it.

No amount of proof or reasoning seems to change this.

I know the first time I read a book on value investing (it was The Intelligent Investor by Ben Graham) I was convinced.  Lock, stock, and barrel.

As Warren puts it most succinctly in his famous speech, “The Superinvestors of Graham and Doddesville”:

One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is. A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he’s applying it five minutes later. I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of IQ or academic training. It’s instant recognition, or it is nothing.

In the same speech, Warren makes it clear that the enormous outperformance of people he personally knew, before their outperformance had started, who followed value investing but invested in very different companies over their investment careers, could not be due to chance alone.

This isn’t surprising, when you realize that many studies show that value investing consistently outperforms the market in the long run.   That, along with reading Warren’s speech, will help you begin to realize:

Why value investors almost always make money in the stock market

The title of this post could be more accurately put as above, but it wouldn’t attract nearly as many people to this simple but powerful message.

The reason why value investors almost always make money in the stock market is simple:  They follow investing methods that have worked for hundreds of years (admittedly long before the term value investing came about), and buy things when most other people are too scared to do just that.

Amazingly to most people, the excess gains from value investing are still here.

I used to be surprised about this, but after seeing how crazy investors were during the tech bubble and now housing bubble, it’s not surprising that more people don’t follow value investing.

But you can.  You can learn all about value investing and join the small group of people who almost always beat the market over the long run.

Of course, you’ll need to know more than just value investing.  You need to learn the psychological pitfalls that most investors fall into, you’ll need to know some of the places to look for value, and you’ll need to have the stomach to buy and hold when there is blood in the streets.

You probably already know a lot more than I’m giving you credit for, but I’d love it if you joined me in the journey to learn more about value investing and other critically important investing lessons.

If you’re willing to go on that journey, just subscribe to Happily Ever After Investing today.

Related posts:

1. 4 Reasons Why Most People Can’t Beat The Stock Market
2. How To Go The Distance With Mr. Market
3. How To Run Against The Wind For Good Stock Market Results

You know how that turned out.  Cinderella became a princess, even though her step-mother and step-sisters thought she was destined to scrub floors ’til the end of her days.

To find a story stock worth investing in, you’ve got to search for your own Cinderella:   A story worth believing in, but which is ignored or looked down upon by most other people.

The problem is, most people end up stumbling onto story stocks that have ugly endings, and there are clear psychological reasons why this is so.

But when a story stock is off the radar screen or openly shunned by other investors, it may be selling at bargain basement prices.  If it is, and there is potential behind it that others just can’t see, you may have found your own Cinderella.

Let’s look at one of the most outstanding examples of a true story stock.

The rich man and the newspaper

Warren Buffett started his business and investing career by delivering newspapers and investing the profits into stocks he researched on his own.

He was only 13.

Among the papers Buffett delivered was The Washington Post.  Perhaps it was this childhood connection with the Post which eventually led him into trying to convince its owner Kathryn Graham to buy the New Yorker, of which Buffett had a small stake by 1971.  The deal fell through, but Buffett’s fascination with The Washington Post Company did not.

Two years later, the total stock market capitalization of the company stood at $80 million, but Buffett’s conservative estimate of its intrinsic value was $400 million.

It was as if he had stumbled onto his own Cinderella, one known by many but shunned by most.  Seeing that he had his eyes on a story stock selling at a bargain price, Buffett bought $10.6 million in stock over several months time in early 1973.

As of the end of financial year 2008, the value of that $10.6 million investment had grown to $676 million, a return of over 60 times, and a true fairy tale ending to a story stock.

But I’m not Warren Buffett…

And you’re right.  None of us are.

That’s why you need to learn the lessons that he has ingrained in him.  Like not trusting all of the story elements about a company nearly as much as he trusts hard numbers.

You need to analyze stocks exactly like a true value investor would, which is what Buffett learned from his mentor Benjamin Graham.

Don’t worry, I won’t leave you hanging and never teach you how to invest like the best value investors, but it’s going to take more than a few short words to do so, and this article is already longer than you’d like.

For now, remember that humans have a tragic tendency:  The more we know about a stock, the more likely we are to believe in it having a happy ending, even though our accuracy in picking winners doesn’t go up at all.

That’s why you need to stay away from most story stocks, they usually have bad endings.

The true happy endings are to be found through value investing and an in depth understanding of bubbles and their causes.

But for now, let’s look at another lesson from the story of Cinderella, so that you’ll be more likely to find a story stock with a happy ending.

A surprising ending

Everyone was surprised when they found out who the girl with the glass slipper really was.  Everyone except you, of course.

Putting things a little more crudely, Cinderella’s value shot through the roof when she put on the abandoned glass slipper.  Her true value had gone way up.

Imagine if it hadn’t been Cinderella’s slipper, but instead belonged to the girl that everyone in the town thought was the prettiest.  Very few people would have been surprised, and the value of the pretty girl in others’ eyes would have only gone up a smudge.

Well, the same is true of stocks.  As one of the most famous value investors out there, David Dremen, puts it:

Earnings surprises have a consistent and predictable effect on stock prices.  More to the point, their impact on stocks that people like is dramatically different from their impact on stocks they don’t like.  Understanding the nature of surprises provides a high-probability method of beating the market. ¹

A mouthful, right?  But David would recognize the parallel with the Cinderella story right away:  Undervalued stocks, like Cinderella, see their worth shoot up very quickly when met with unexpected but good surprises.

And the opposite is true as well.  Story stocks, at least the ones that everyone love, plummet in value when a bad surprise reveals itself.

Up is down, and down is up

Let’s put this in real terms.  Dremen looked at the effect of earnings surprises on stock prices.  That is, when a company came in below or above analyst’s earnings estimates for a financial quarter, by as little as one cent.²

What he found was fascinating.  Stocks that were unloved by the market, ranked in the bottom 1/5 of stocks measured by their price to earnings ratio, shot up in price when they had positive earnings surprises, rising 3.6% over the market return in the same quarter and 8.1% for the full year.

And these Cinderella-like stocks didn’t see their values fall much if at all with negative earnings surprises.  After all, no one in Cinderella’s town would have been surprised if the glass slipper hadn’t fit.

On the other foot, the counterpart to Cinderella stocks, ranked in the top 1/5 of stocks measured by their price to earnings ratio, plummeted in price when they had negative earnings surprises, falling 4.3% below the market return for the quarter and 8.9% for the year.

By now you should easily be able to guess that a positive earnings surprise had almost no effect on the value of these favored stocks.   Just like if it hadn’t been Cinderella who fit the glass slipper but the town beauty, the value of these stocks stayed mostly the same after a positive surprise.

Getting to your own happy ending

If you want to find a real story stock, you need to look where nobody else is looking.

After all, that’s how Cinderella was found, and it’s your best way of getting to your own happy ending.  So long as you subscribe to Happily Ever After Investing, that is =)

Related posts:

1. Sinister Story Stocks: Why You Shouldn’t Believe In Most Happy Endings
2. Why Some People Almost Always Make Money in the Stock Market
3. How To Go The Distance With Mr. Market

But first, let me ask you something:  Have you ever fallen for a story stock?

At first you think your stock will have a fairytale ending, but it ends up more like a tragedy. I know, it’s happened to me more than a few times.

Why do we keep believing in stories that refuse to come true?

The answer lies deep within the recesses of your mind, where some common psychological traps lie await for the unsuspecting investor.  If you want to learn how to avoid these traps, keep reading.

Irradicating the information illusion

Did you know that for diseases that are only possible to spot by considering combinations of symptoms, like gastric ulcers, a doctor’s accuracy is not very high?¹

Knowing that your doctor is not as accurate as you might think can be scary on its own.

What should really make you go scrambling for a second opinion is this: As your doctor learns more about your symptoms and conditions, he becomes more confident in his diagnosis.  What’s shocking is that his accuracy stays the same.

He becomes more confident, but not more competent.

The problem is not restricted to doctors, though.  Track handicappers face the same problem.  In one study, handicappers were given from 5-40 pieces of information they considered important for picking winning horses.  Their accuracy with five pieces of information was the same as with forty, but their confidence went to almost twice its original level!²

So what’s that got to do with choosing individual stocks?

Unsurprisingly, investors face the same problems processing increasing amounts of information.

It’s simple: the more background and facts you dig up about a seemingly kick-ass investment, the more confident in it you will become. That’s dangerous, especially because your accuracy in finding a true story stock probably hasn’t gone up at all.

Another study shows that professional investors do not correctly process extra information, even though their confidence goes up.³

You and me are the same.  The more we learn about a stock with a good story, the more likely we believe it will have a happy ending.

So what can you do to select stocks that really do have fairy tale endings?

That’s what the next post is about.  Read on to find out What Cinderella Can Teach You About Story Stocks With Happy Endings.

Or subscribe to Happily Ever After Investing so you can find real story stocks that will help you reach your own happy ending.

Related posts:

1. What Cinderella Can Teach You About Story Stocks With Happy Endings

Feeling a bit beat up by the market?

You’re not alone. Investors around the world, including pension funds, sovereign investment funds, and countless individuals like you and me have been hit hard over the past year and a half.

And it’s Mr. Market doing the beating.

Now the real question is this: Will you get up and go the distance with him?

Getting pulled apart at both ends

There are two things standing between you and a victory over Mr. Market:  Your head and your money.

The first is the battle of emotions within.   It’s hard to keep buying value stocks after they’ve been pummeled into the ground, but it’s the best time to buy them.

If you want to beat Mr. Market, you need to get your head on straight — now.   Not when everything looks rosy, not when you are sure you can win, but now, when everything looks hopeless and the blood is dripping from that fresh wound over your eye.

Stand up and start hitting back.

Keep buying things when they’re cheap, which is now.  Look for the best deals abroad.  Learn everything you can about investing.  And keep on fighting.

But there may be something else holding you down to the mat. Your income or even your job may have gone down for the count. If so, you might have no other choice but to sell today.  But do anything you can to get back up again, and get back in the ring.  If you do, and you hit Mr. Market in all the right places, you’re going to end up a very happy and gloating person, towering over the remains of Mr. Market.

If you’re lucky enough to still be making what you were in years past, cut out as many expenses as you can and use the difference to get back in the ring.  Save now, because the fight has just started.

You won’t have the chance to knock Mr. Market down forever.  Do it while he thinks he’s the strong one.

Over to you: Are you using this chance to fight back at Mr. Market, or are you rolling over and playing dead?

Related posts:

1. Why Some People Almost Always Make Money in the Stock Market
2. 4 Reasons Why Most People Can’t Beat The Stock Market
3. Are Your Emotions Keeping You From Beating The Market?

It’s a pretty important question.

Now, you might not believe it if I told you, but if you hold any significant amounts of dollars or dollar backed bonds, they are tying you down to these tracks.

How you untie yourself and how to get out of the way isn’t rocket science, but digging deep enough to discover the dollar’s ultimate fate is a little more difficult.

So let’s see what’s coming down the tracks.

More money than you can shake a (hockey) stick at

Take a look at the graph below (from here):

It shows the amount of base money that has been created, like it always is, by the Federal Reserve.

Notice the giant hockey stick like shape? Graphs from the peak of the housing bubble and stock market bubble look eerily similar.

But there’s a big difference between then and now, and that is this: there is no limit to how much money the Federal Reserve can create out of thin air. The hockey stick could point a lot higher, and already is poised to do just that.

Just days ago the Federal Reserve showed it’s hand:  It increased it’s balance sheet from $900 billion last September to $1.8 trillion today, and is in the process of increasing it to $3 trillion by the end of the year.  This from the New York Times:

But to the surprise of investors and analysts, the committee said it had decided to purchase an additional $750 billion worth of government-guaranteed mortgage-backed securities on top of the $500 billion that the Fed is already in the process of buying.

In addition, the Fed said it would buy up to $300 billion worth of longer-term Treasury securities over the next six months. That would tend to push down longer-term interest rates on all types of loans.In effect, the central bank has been lending money to a wider and wider array of borrowers, and it has financed that lending by using its authority to create new money at will.

Since last September, the Fed’s lending programs have roughly doubled the size of its balance sheet, to about $1.8 trillion, from $900 billion. The actions announced on Wednesday are likely to expand that to well over $3 trillion over the next year. (From here)

Base money is what banks multiply through fractional reserve banking.  When the base increases, a similar increase in prices will occur if the base money isn’t bought back with the assets of the Federal Reserve.

The assets the Federal Reserve are buying today  are likely to drop in value.  The only reason the Federal Reserve would buy government guaranteed mortgage backed securities is if they weren’t worth what they bought them for.  Plus any rise in long term interest rates would cause both the mortgage backed securities and long term treasury bonds to fall in price.

If that happens, how much of the base money will they be able to mop back up?

Can you hear the train’s engine car starting up?

Scared foreigners

Every increase in the money supply and government spending makes foreigners ever more hesitant to hold onto dollars.

While 2008 saw a flight to the dollar, foreigners are starting to seriously question whether it is a safe place for their money.

Just look at what one of the top leaders from America’s biggest creditor had to say on Friday the 13th (March 2009):

Chinese Premier Wen Jiabao said Friday that he has “worried” about the safety of U.S. assets — meaning the Treasury bonds his government owns. Whatever Mr. Wen’s political motives, his concerns about the integrity of U.S. sovereign debt are timely and apt.

President Obama’s stimulus plan and new budget will require an additional $3 trillion to $4 trillion in new borrowing over the next two or three years, and that’s if the economy recovers smartly. Adding it all up, Federal Reserve Chairman Ben Bernanke earlier this month estimated that U.S. public debt-to-GDP would reach 60% over the next few years, up from 40% before the financial panic hit — and the highest level since the aftermath of World War II. (…)

Mr. Wen called on the U.S. to “maintain its credibility, honor its commitments and guarantee the safety of Chinese assets.” Little wonder: China, like other trading nations, has a big stake in this fiscal free-for-all. Although it doesn’t release detailed data, roughly two-thirds of Beijing’s $1.9 trillion foreign-exchange reserves are likely parked in U.S. Treasury debt. (From here)

China is getting nervous, and isn’t the only one.  Their fears about the dollar losing value are far from unfounded, as we saw above with how much money the Federal Reserve is creating out of thin air.

If the leaders of America and the Federal Reserve don’t take this warning seriously enough, we could end up with  a real horror story.  A massive flight from the dollar.

And with foreigners now holding 50% of America’s public debt (up from 5% in the 1960s, see here), foreigners selling the dollar would not be of minor significance.

It would derail the dollar.

From caboose to kaboom

Today, most people think of America as the engine of the global economy. But America is not the engine. It can only consume so much because it borrows so much, which means it’s really the caboose.

After all, if foreigners didn’t lend Americans so much money, we wouldn’t be able to consume so much.  When foreigners start selling dollars, the result will not only be that other countries will stop pulling America around like a caboose.

Instead, it will be as if the engine car turned around and slammed full force into the caboose.

The dollar will plummet.  The only question is how far.

And that depends on how the Federal Reserve reacts to this impending crises.

Pain now or printing and much more pain later

When foreigners all around the world start selling en masse, the Federal Reserve will have two choices:

1. Print more money and buy back the treasury bonds
2. Let interest rates skyrocket

If the Federal Reserve keeps printing Money, the dollar will fall to a small fraction of its former value.  If it lets interest rates skyrocket, long term bonds will plummet, and the dollar will hold some of its value.

But if interest rates skyrocket, the Federal Reserve won’t be able to mop up the extra dollars it is creating today.

So whatever it chooses to do, the damage will have been done.  The value of the dollar will already be toast.

You can probably hear the freight train on its way.  Now what’s the best way to jump out of the way?

Sell dollars, and buy what?

It’s a common idea these days that since foreign stocks, currencies, and commodities have all taken a beating, that dollars are the only safe thing to hold.

The truth is exactly the opposite.  As any value investor will tell you, buy when things are cheap.

The dollar is not cheap today.  But many foreign stocks are extraordinarily so.

So jump out of the way of the oncoming freight train and start exploring foreign waters for good deals.

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